Doing the Roth Arithmetic

It's clear to me, even though it may not be clear to you, that unless
there is something very unusual about your situation, if you have a
traditional IRA, you should pay the tax now and convert it to a Roth
IRA. Not just maybe, but definitely. Not just for a small advantage but
for a big one. If you don't convert today, you'll ultimately surrender
much more to the tax collector. You'll be throwing money away. And
you'll keep throwing it away. It's a result neither of us wants.

Your
IRA is an object in motion, with money going in and out of it and
investments turning over inside of it. It lives not just on your
brokerage statement but across the years of your calendar as well.
That's why the Roth conversion question can seem so tangled. Because of
the time dimension, deciding whether to convert isn't as simple as
deciding whether to replace one stock with another. But there is, as
I'll try to show, a way to look at the question that cuts through the
complexity.

Comparisons

With a traditional
IRA, you are allowed to contribute $5,000 per year of employment income
(or $6,000 if you are 51 or older), and, if your income isn't too high,
you receive a tax deduction for the contribution. Earnings inside the
IRA accumulate and compound free of current tax. Later, when you
withdraw the money, it comes to you as taxable income (except to the
extent of any contributions that weren't tax deductible when made, which
come out tax free).

With a Roth IRA, if your income isn't too
high, you may contribute up to the same $5,000 or $6,000 per year, but
none of it is tax deductible. Just as with a traditional IRA, earnings
inside the Roth accumulate and compound free of current tax. When the
money comes out, assuming you are at least 59.5 years old and the IRA is
at least five years old, the money goes tax free straight to your
pocket.

Whether traditional or Roth, any IRA's power to make you
richer comes from tax-deferred compounding. Consider a simple example
that compares an ordinary, taxable savings account with a traditional
IRA. Assume, for the sake of simplicity, that:

An individual is willing to forgo $1,000 of current spending.
He's putting money away for 30 years.
His income tax bracket (federal and state) during the 30-year period is a constant 40%.
The before-tax rate of return is a constant 5% per year.

The
ordinary savings account starts with $1,000, the amount of current
spending the investor is willing to forgo. Given a 40% tax bracket, the
earnings compound at an after-tax rate of 3%, so at the end of 30 years,
the investor has $2,427 in spendable cash.

The traditional IRA
starts with $1,666.67, since, given the tax deduction and a 40% tax
rate, that's the amount that entails forgoing $1,000 of current
spending. The earnings will compound at a tax-deferred rate of 5%, so at
the end of the 30 years there is $7,203 in the traditional IRA. When
the investor withdraws the entire amount and gives up 40% in tax, he's
left with $4,322 in spendable cash – 78% more than if he hadn't used the
IRA.

How does a Roth IRA stack up against a traditional IRA? Redo
the calculations for a Roth and you find the same result, to the penny.
The Roth starts with $1,000. The earnings grow at a tax-free rate of
5%, so at the end of the 30 years, there is $4,322 in the Roth IRA. And
since withdrawals from a Roth can be tax free, it's all spendable cash.

There
is a fourth possibility, which I'll call a "Lame IRA." A Lame IRA is a
traditional IRA that has been funded with contributions that were
non-deductible because the owner's income was too high. Like the Roth,
it starts with $1,000, and at the end of the 30 years the balance is
$4,322. But of that amount, $3,322 is taxable when it is withdrawn.
After paying tax, the owner is left with just $2,992 in spendable cash.
This is the weakest outcome for an IRA, but it still beats an ordinary
savings account.

The Free Hand You Don't Have

A
78% improvement in wealth accomplished with a traditional IRA is a big
payoff for filling out a few papers. So if you had a free hand – meaning
if there were no contribution limits – how much of your income and
assets should you put into a traditional IRA?

Part of the answer
is easy: any interest-earning dollar assets (cash, money market funds,
T-bills, taxable bonds, etc.) that are part of your overall portfolio
should go into the IRA. In your hands, the interest they earn is heavily
taxed. Inside the IRA, the interest is tax-deferred. The ideal IRA
would be at least big enough to hold all your interest-earning dollar
assets.

The same goes for any part of your portfolio that you plan
on devoting to short-term trading – trades that you expect to last for
less than one year and hence would generate short-term capital gains.
Unless you have an unhappy inventory of capital losses, your short-term
capital gains will be taxed at the same rate as ordinary income, and
they'll be taxed currently – unless they happen inside your IRA. So your
ideal IRA would be big enough to hold all your short-term trades as
well.

Longer-term positions are a different matter. Unless your
traditional IRA has a long life ahead of it (at least 20 years), you
shouldn't expand the IRA to make room for stocks you are holding for
more than one year. Putting those stocks into the IRA risks a reverse
alchemy – converting lightly taxed long-term gains into ordinary income.

What
about gold? The top federal tax rate on gold profits is 28%, which,
depending on your state, gets the bill to, perhaps, 34%. In any case,
the rate is less than the ordinary income rate you pay when profits come
out of a traditional IRA. So if you are planning to liquidate a
traditional IRA within the next few years, it's not the place to hold
gold. But if your IRA is going to stay in business for another decade or
longer, you likely will be selling much of the gold and reinvesting in
something else, including interest-earning assets and perhaps short-term
trades. In that case, yes, the ideal size for a traditional IRA would
be big enough to hold most of the gold that is part of your overall
portfolio.

So, in general, moving your directly owned assets into a
traditional IRA would be to your advantage. But there are limits.
Moving assets whose return is taxed lightly could be a mistake.

With
a Roth IRA, however, the picture is much simpler. Ideally, if it were
possible, all your investments should be wrapped up in a Roth, for zero
tax when profits are earned and zero tax when profits are paid out to
you. Of course, that ideal isn't available, but it demonstrates that
with a Roth IRA, bigger is unambiguously better. And that gets us closer
to answering the Roth conversion question.

Deconstructing a Traditional IRA

Again
assume, for the sake of simplicity, that you face a constant tax rate
of 40% far into the future. Regardless of how wonderfully profitable the
investments in your traditional IRA turn out to be (or how
disappointing), and no matter how long the money stays in the IRA, 40
cents of every dollar that comes out will be lost to taxes. You'll only
get the 60 cents to spend. In other words, your traditional IRA is in
fact a 60/40 partnership between you and the government.

Now take a
close look at your 60% share, which is all you really own. Its returns
are free of current tax. And when the partnership liquidates (when money
comes out of the IRA), you'll collect your 60% share tax free. Sound
familiar? Your 60% share of a traditional IRA is indistinguishable from a
Roth IRA. It is a virtual Roth. And the other 40% isn't yours at all.

Traditional IRA

Government's share = 40%

Your Virtual Roth IRA = 60%

Viewing
a traditional IRA in that light, if the government were willing to sell
its share and you could use your directly owned (non-IRA) assets to buy
it, would it be smart for you to do the deal? The effect of a buyout
would be to move your directly owned assets from their high-tax
environment into the shelter of a Roth IRA. And we've already
established that it is always better to have a dollar in a Roth than to
have a dollar in your pocket. So if the government invites you to buy
them out, you should almost certainly accept the offer.

In fact,
the government is making you such an offer right now. It's called a Roth
conversion. Accept the offer. It's a migration of assets from a
high-tax environment to a zero-tax environment. Unless you believe that
income tax rates are going to decline drastically, put your wealth on
the boat.

Four More Factors

Moving more of
your financial life into a tax-free Roth zone is by itself a compelling
reason to make a Roth conversion. But there are several more advantages:

Inflation Protection

The
years of rapid price inflation that many of us are expecting will
increase the value of an IRA's tax protection. Inflation generates
profits that are accounting fictions but nonetheless are taxable. A
stock whose price doubles during a period when what you buy at the
grocery store has gotten twice as expensive hasn't delivered a real
profit. But when you sell the stock, your "gain" will be taxed as a
capital gain... unless the stock is in your IRA.

The tax picture
for interest-earning assets during rapid price inflation is even uglier.
Yields on money market instruments tend to rise along with inflation
rates, on average leaving the investor with a real, after-inflation
return of about 1%. When inflation is running at 14%, for example, you
can expect money market returns to be in the 15% neighborhood. But the
entire 15%, not just the 1% true return, will be taxed – unless the
investment is in a shelter such as an IRA. Avoiding a big tax bill on
fictitious income adds to the importance of sending as much of your
wealth to Rothland as possible.

No Minimum Distribution Requirement

With
a traditional IRA, you must take a minimum distribution every year
starting at age 70.5. Your IRA is forced into a slow liquidation, which
pushes wealth back into the environment of full taxation. Dollar by
dollar, tax deferral comes to an end.

With a Roth IRA, on the
other hand, there are no minimum distribution requirements. You can let
the money ride as long as you like. In nearly all cases, the best
approach is to not touch the Roth until you've run out of directly owned
assets. For many investors that means letting the Roth grow tax free
for years past age 70.5.

Heal the Lame

If
any of your contributions to a traditional IRA weren't tax deductible
when you made them, your IRA is, to that extent, lame. The tax cost of
moving those contribution dollars to a Roth is exactly zero, and the
future earnings of those dollars can come out of the Roth tax free.

Additional Tax Savings

The
range of investments that the tax rules permit an IRA to hold is broad –
far broader than what you can get with any stockbroker, mutual fund
family or insurance company. An IRA is authorized to own real estate of
any kind, for example. It can own copyrights, patents and other
intellectual property and collect royalties. It can own an
equipment-leasing business. It can even have a foreign bank account.

Anyone
can gain access to such investments for his IRA by moving it to a
custodian that will allow the IRA to own a limited liability company.
The individual manages the LLC that his IRA owns, and the LLC buys and
owns the investments. It's a way to free yourself up to invest IRA money
in almost any way you choose.

The structure can provide an
additional benefit. It can cut the tax bill on a Roth conversion by
one-third or more. That is accomplished by adopting a valuation strategy
that has become commonplace in estate planning.

The amount of
taxable income that you recognize on a Roth conversion is equal to the
"fair market value" of the property that moves from the traditional IRA
to the Roth. For all tax purposes, fair market value means the price
that would occur in a transaction between a willing buyer and a willing
seller. If the property is a non-controlling interest in an LLC, its
fair market value will depend on what's in the LLC and also on the terms
of the operating agreement that governs the LLC. With the right terms,
that fair market value can be pushed far below the interest's pro rata
share of the LLC's assets.

An example may make this less mysterious.

Suppose
you have a traditional IRA that owns an LLC that in turn owns $100,000
worth of marketable stocks. Under the terms of the LLC's operating
agreement:

The Manager (you) has the discretion to make distributions at whatever time the Manager chooses.
No owner of an interest in the LLC may sell it without the consent of the Manager.
The Manager can be replaced, but only with the unanimous consent of the owners.
The LLC can be liquidated, but only with the unanimous consent of the owners.
The operating agreement can be amended, but only with the unanimous consent of the owners.

How
much would anyone be willing to pay for a 50% interest in your IRA's
LLC? Certainly not $50,000. All he would be getting is the right to wait
for you to decide to make a distribution, and he would have no power to
get rid of you or to change the rules. So the fair market value of the
50% interest would be less than $50,000. How much less? A professional
appraiser would tell you the fair market value of the interest is no
more than $35,000 (possibly even less than that).

That valuation
discount translates into tax savings. Move a 50% interest in the LLC to a
Roth, and you recognize taxable income of only $35,000. The following
year, repeat the exercise. That will put the entire LLC, with its
$100,000 of assets, under the Roth umbrella, and you will be paying tax
on just $70,000 of income.

Jumping

The
advantages of converting a traditional IRA to a Roth stack up. Move more
of your wealth into a tax-free environment. Achieve greater inflation
preparedness. Escape the rules on required minimum distributions. Turn
non-deductible contributions into a generator of earnings you can
withdraw tax free. Cut the tax cost of getting spendable cash from the
IRA by using a valuation strategy when you convert.

The advantages
stack up so high that if your traditional IRA could read this article,
it would be jumping around the room and waving its arms high and
shouting "Convert me! Convert me!" I hope you can imagine hearing that
advice and taking it. Every time you or anyone else acts on a legitimate
opportunity to save on taxes, he deprives the government of the means
for more mischief. You'd be doing us all a big favor. I do my part. Now
it's time for you to do yours.

In addition to his role as
economist and editor with Casey Research, Terry Coxon is a principal in
Passport IRA and the author of Unleash your IRA.

The
information included in this article is not to be construed as legal or
tax advice; should you consider a Roth conversion, make sure to discuss
your plans with your own CPA and tax advisor.